Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment

Krishnamurthy, Arvind; Li, Wenhao

doi:10.2139/ssrn.3554788

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Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment

81 Pages Posted: 9 Apr 2020 Last revised: 7 May 2024

See all articles by Arvind Krishnamurthy

Arvind Krishnamurthy

Stanford Graduate School of Business; National Bureau of Economic Research (NBER); Stanford University - Stanford Institute for Economic Policy Research

Wenhao Li

University of Southern California - Marshall School of Business; National Bureau of Economic Research (NBER)

There are 2 versions of this paper

Date Written: May 12, 2024

Abstract

We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. The model accounts for the entire crisis cycle, matching data on the frothy pre-crisis behavior of asset markets and credit, the sharp transition to a crisis where asset values fall, disintermediation occurs and output falls, and the slow postcrisis recovery in output. Both the intermediation and belief mechanism are essential to match the crisis cycle. However, modeling the belief variation via either a Bayesian or diagnostic model can match the broad patterns.

Keywords: financial crises, intermediation, sentiment, credit spread

JEL Classification: G01, E44

Suggested Citation: Suggested Citation

Krishnamurthy, Arvind and Li, Wenhao, Dissecting Mechanisms of Financial Crises: Intermediation and Sentiment (May 12, 2024). Available at SSRN: https://ssrn.com/abstract=3554788 or http://dx.doi.org/10.2139/ssrn.3554788